Financial systems and development

Box 7.3 The financial history of a Pakistani firm
Ajmal Hosiery, a family-owned business in Lahore, its Export Refinance Scheme, which provided cheap
Pakistan, was established by Malik Ahmad Din in 1947. financing to eligible exporters through the commercial
He began with an abandoned hosiery mill and two banking system. The firm could not exploit the scheme
obsolete knitting machines. By the late 1950s the firm fully because banks thought its collateral inadequate.
was well-known across the country.
Nevertheless, the scheme helped the company to reach
Malik's original scheme was to let his business grow sales of Rs5.0 million in 1979, by which time its bank
at a pace that would require no external financing, be- credit line amounted to Rs1.3 million.
cause he was uncomfortable with the paperwork in- The firm had always relied solely on internally genervolved
in getting a loan. Moreover, he feared that infor- ated funds to finance investment. Consequently, inmation
given to financial institutions could be used by vestment in plant and equipment had not kept pace
the tax authorities. The company grew modestly dur- with sales. In 1976, however, it obtained a long-term
ing its first twenty years by plowing profits back into loan of Rs1.0 million to expand its capacity; the lender
the business. Sales increased from around 50,000 ru- was the Industrial Development Bank of Pakistan.
pees (Rs) in 1947 to Rsl.3 million in 1969. The company has grown dramatically during the
The company obtained its first bank financing-an 1980s. It has used the government's enlarged export
Rs5O,000 line of credit-in 1969 when it executed its financing scheme and has also obtained term financing
first export order. This venture into the international (in 1980, 1984, and 1988) for modernizing its plant and
market was not successful; it cost the company equipment. Sales grew fivefold between 1980 and 1988.
Rs100,000. The company reentered the export market In 1989-90 the firm plans to reach sales of Rs9O.0 milin
1972 but could obtain a line of credit of only lion, a figure three times higher than its 1988 sales of
Rs200,000 from a local bank. Although there was clear Rs3O.0 million and 1,800 times its sales of Rs5O,000 at
potential for exports, the firm needed working capital inception in 1947.
finance. In 1973 the State Bank of Pakistan introduced
is a poor substitute for price stability. Allowing in- mediaries. Bankers everywhere, however, are restitutions
to charge interest rates that reflect the luctant to lend to small borrowers. First, they may
higher risks of longer-term lending will increase its find it uneconomical to lend the small sums resupply,
as will improvements in legal and account- quired. Second, it is difficult to judge the risk, paring
systems that increase lenders' ability to moni- ticularly when an investment project is a new ventor
and control their clients. Relatively risky ture. Small firms often lack a track record and
projects should be financed with equity capital, rarely keep reliable accounts. Third, small borrowwhere
repayment is linked to profits; long-term ers often lack adequate collateral.
loans with fixed returns are unsuitable for such In developing countries, bankers' reluctance to
projects. lend to small firms has been compounded by other
factors. Financial policies have left small firms un-
AcCESS TO FINANCE. Many governments have able to compete for credit on the same terms as
sought to improve the access of smaller firms to larger firms. Most directed credit programs have
finance, partly for social reasons and partly be- discriminated against small borrowers. Interest
cause such firms are often thought to be the most rate ceilings have prevented lenders from raising
dynamic part of the economy. Although small- interest rates to compensate for additional risk and
scale manufacturing, service, and commercial higher costs. And small firms have less political
firms are generally less capital-intensive than influence: lenders know that governments are unheavy
industry or housing and thus have consider- likely to intervene on behalf of a failing small firm.
ably smaller investment needs, they should have In short, the policies that led to overleveraging
access to credit if they can use it more productively by many large firms have also limited access to
than larger borrowers. As Box 7.3 illustrates, credit credit for small borrowers. Changing those policies
can allow a small firm to invest and grow. will improve the flow of finance to small firms. In
Because small firms have little name recognition, addition, measures that improve the links between
they can neither borrow abroad nor issue equity. formal and informal financial markets (discussed
They depend for external funding on trade credits in Chapter 8) would serve the same purpose.
from other firms or on loans from financial inter- Financial innovations that secure loans by means
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